Stocking up on products to meet sales goals, a practice that is promoted with claims that it will push the new distributor to higher bonus and/or leadership levels quickly. In reality, it increases the risk of significant financial loss if sales do not occur.

If an individual pays $59 and signs-up as an Herbalife Distributor one is immediately entitled to purchase product for 25% off SRP plus applicable Shipping and Handling fees. However, the first thing the compensation scheme encourages is upfront inventory loading.

Inventory loading is the reason upline distributors make money on purchases and not sales. It is the reason downline distributors don't. It is the reason the top of the pyramid remains stable. It is the reason the bottom of the pyramid churns like a Maytag on spin cycle. This is also the reason Herbalife is likely a pyramid scheme.

The minute a new recruit signs-up as a distributor:

if a new recruit buys 500 Volume Points (VPs) the wholesale discount increases to 35%

if a new recruit buys 1,000 VPs one time the discount is 42%

if a new recruit buys 4,000 VPs the discount is 50%

also, the distributor earns titular recognition if they advance in the scheme. First you become a Senior Consultant, then a Success Builder, then after purchasing 4,000 VPS gets you to Supervisor status.

Supervisor status also gets you the right to earn Royalty rewards

If you requalify every year, you preserve your downline, etc, etc.

Q. What do all of these incentives have in common?

The answer is that not a single one of these promotional incentives must be connected to evidence of a legitimate retail sale at all.

In the Herbalife system, immediately new recruits are encouraged to "buy their discounts" and to "buy their status".

Q. If you just signed-up as a Herbalife distributor, would you be tempted to "buy your discount" or not? What does common sense tell you?

Let's contrast Herbalife's Incentive System to Nuskin (NYSE:NUS). Nuskin distributors all get charged the same wholesale price for product. There is no requirement for a Nuskin distributor to "buy their discount". There is no requirement for a Nuskin distributor to acquire inventory in order to be competitive as a retailer. Herbalife, in contrast, encourages its new recruits to buy inventory to secure a lower COGS and to advance in the compensation scheme.

"...occurring when distributors make the minimum purchases required to receive recruitment based bonuses without reselling the products to consumers."

This definition seems consistent with the definition offered by MLM watch.

As a reminder, Herbalife is a pyramid scheme if it meets the Koscot test.

What is the Koscot test? Again, from Webster v. Omnitrition:

The Federal Trade Commission has established a test for determining what constitutes a pyramid scheme. Such contrivances are characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users.

I am going to rewrite item (2) to say that recruiters can make money even if the people in their downline never make a retail sale.

The satisfaction of the second element of the Koscot test is the sine qua non [a condition without which it could not be] of a pyramid scheme: "As is apparent, the presence of this second element, recruitment with rewards unrelated to product sales, is nothing more than an elaborate chain letter device in which individuals who pay a valuable consideration with the expectation of recouping it to some degree via recruitment are bound to be disappointed."

We adopt the Koscot standard here and hold that the operation of a pyramid scheme constitutes fraud for purposes of several federal antifraud statutes.

What is an "ultimate user"? For the purpose of the Koscot test, an "ultimate user" is an individual who is not a participant in the scheme.

Longs argue that an "ultimate user" is a participant who uses the product for "personal consumption".

Specifically, Herbalife tries to argue that 71% of the company's distributors are just "discount customers" who join up as distributors to get a discount and therefore their personal consumption should be counted as retail sales.

In addition, plaintiffs have produced evidence that the 70% rule can be satisfied by a distributor's personal use of the products. If Koscot is to have any teeth, such a sale cannot satisfy the requirement that sales be to "ultimate users" of a product.

The courts have been clear and consistent on this point. "ultimate users" must be participants outside the scheme.

Why?

Because the courts want to be sure that the compensation that is paid to those doing the recruiting is not financed by inventory loading but rather by actual sell-through of the product to non-participants outside the scheme.

On December 20, 2011 Pershing Square delivered a 300 page presentation arguing that Herbalife is a pyramid scheme because it meets the Koscot test. 2 1/2 months later, Herbalife still has not produced any direct evidence that legitimate retail sales to "ultimate users" actually occur.

Q. Why did the 9th Circuit argue that for Koscot to have any "teeth" an ultimate user must not be a participant in the scheme?

The answer is tied to a simple concept, namely inventory loading.

I submit that the typical life-cycle for a Herbalife recruit is as follows:

A new recruit is seduced into the retail "business opportunity" with promises of great profits

The recruit immediately inventory loads to secure a lower COGS and/or a higher rung on the Success Ladder

The recruit then tries to source retail customers and/or recruit a downline

Due to market saturation the "business opportunity" turns out to be tough sledding

The distributor resigns within a year.

The inventory they acquired gets consumed, tossed away or written off.

The cycle repeats as new recruits are seduced into the retail "business opportunity".

Last year 1.96 million new recruits signed-up while 1.46 million recruits resigned. It is likely that most if not all of these individuals inventory loaded.

As a critical ingredient in this life-cycle, the effect of the inventory load is obvious. Everybody in the upline gets paid on the purchases that the new recruit makes whether or not any of this inventory is ever sold to an ultimate user. In practice, Herbalife and its Sales Leaders encourage inventory loading because they get paid on purchases and not ultimate retail sales.

Price discrimination is the sinister element in the Herbalife compensation scheme. It is the central ingredient that makes Herbalife different from Nuskin and other MLMs. If Herbalife did not charge its distributors different wholesale prices for inventory, distributors would have no rational incentive to inventory load. New recruits would likely purchase a much lower level of opening inventory, Herbalife's net sales would likely decline and the overall risk of financial loss for a new recruit would be reduced. This is what happens at Nuskin but not in the Herbalife world.

Herbalife apologists will pay lip service to the company's return policy, 70% rule and Ten Customer rule as safeguards against inventory loading. In practice the company does not enforce these rules and the company's return policy requires the following of its distributors:

a distributor must resign to return product

a distributor must absorb all Shipping and Handling fees paid on both the purchase and the return of product

the paperwork required is onerous and time consuming

the return policy requires the company to claw-back Volume Points and commissions paid to a Supervisor. This encourages Supervisors to be uncooperative if their downline recruits fail.

Q. Do we have evidence in the Herbalife 10k that inventory loading is occurring in the Herbalife business model?

1) In an article I wrote titled Herbalife is an Endless Chain an analysis of Herbalife's historical Net Sales data reveals that the company's net sales grows in a 1:1 relationship with the growth of its new recruits. This analysis underscores the idea that new recruits are inventory loading and not personally consuming. If new recruits were not inventory loading we would clearly expect the company's net sales per new recruit to be less than the net sales of existing distributors. We would also expect more modest purchase volume for personal consumption. Instead, we see obvious evidence that sales volume growth is directly tied to the purchases of new recruits in a linear fashion.

2) The company's net sales data is also consistent with this behavior. The average net sales per distributors is $1,290. The average net sales per new recruit is $2,079. These volume amounts are consistent with what we would expect to see of a distributor attempting to buy their discount. These data points fit squarely with the acquisition of a 42% to 50% discount on product. If you didn't watch the video link at the beginning of this article, I encourage you to do so to get what I mean.

3) The overwhelming conclusion reached from examining actual business activity in the end-market for Herbalife product reveals that very little product is being sold at full SRP. In practice, most product is aggressively discounted to prices 25% off or more. This fact makes it essential for new recruits to inventory load if they ever want a legitimate chance to make any retail margin on sales to actual users.

In Webster v. Omnitrition the 9th Circuit reminds us categorically that we must look at the entire system of compensation to meet the Koscot test, not just the most Junior levels of the pyramid.

Looking further up the chain in the pyramid, on the subject of the role of Supervisors in the Omnitrition scheme, the court also had the following to say:

To become a supervisor, a participant must pay a substantial amount of money to Omnitrition in the form of large monthly product orders. (in the case of Herbalife a Supervisor must generate 4,000 VP and requalify each year). The "payment of money" element of a pyramid scheme can be met where the participant is required to purchase "non returnable" inventory in order to receive the full benefits of the program. (in the case of Herbalife, Royalty rewards are not available until you reach the Supervisor level)In re Amway Corp., 93 F.T.C. 618, 715-16 (1979).

In exchange for these purchases, the supervisor receives the right to sell the products and earn compensation based on product orders made by the supervisor's recruits.This compensation is facially "unrelated to the sale of the product to ultimate users" because it is paid based on the suggested retail price of the amount ordered from Omnitrition, rather than based on actual sales to consumers.

The court goes on to say:

On its face, Omnitrition's program appears to be a pyramid scheme. Omnitrition cannot save itself simply by pointing to the fact that it makes some retail sales. See In re Ger-Ro-Mar, Inc., 84 F.T.C. 95, 148-49 (1974) (that some retail sales occur does not mitigate the unlawful nature of pyramid schemes), rev'd on other grounds, 518 F.2d 33 (2d Cir.1975).

The promise of lucrative rewards for recruiting others tends to induce participants to focus on the recruitment side of the business at the expense of their retail marketing efforts, making it unlikely that meaningful opportunities for retail sales will occur. Koscot, 86 F.T.C. at 1181. The danger of such "recruitment focus" is present in Omnitrition's program. For example, Webster testified that Omnitrition encouraged him to "get to supervisor as quick as he could."

Furthermore:

Ligon states:The product sales are driven by enrolling people.In other words, the people buy exorbitant amounts of products that normally would not be sold in an average market by virtue of the fact that they enroll, get caught up in the process, in the enthusiasm, the words of people like Charlie Ragus, president, by buying exorbitant amounts of products, giving products away and getting involved in their proven plan of success, their marketing plan. It has nothing to do with the normal supply and demand in this world. It has to do with getting people enrolled, enrolling people, getting them on the bandwagon and getting them to sell product.

What the 9th Circuit effectively describes here in its ruling is inventory loading.

Herbalife's entire compensation system encourages inventory loading.

Supervisors need to requalify every year to preserve their downlines. The "pay to play" element is apparent.

Supervisors aggressively recruit participants and encourage them to inventory load

Supervisors get paid on purchases and not retail sales

New recruits can also "buy discounts" or "buy status" or both

All compensation in the scheme is paid on purchases and not sales

Inventory loading does not appear to be a material problem for Nuskin as you look at its MLM model. Distributors may be encouraged to acquire inventory to secure recruiting rewards, but there is no requirement to acquire inventory to secure a discount on product. This makes it reasonable to conclude that inventory purchases are likely closely connected to actual retail demand for Nuskin.

This is the tragic flaw that sets new recruits up to fail. 85% churn out in less than a year. Inventory loading victimizes new recruits underwritten by price discrimination. Inventory Loading is the reason ultimate users must be outside the scheme to satisfy the Koscot test.

Disclosure: I am short HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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